Transcript fixed exchange rates

Chapter18
Exchange Rates
Macroeconomics
Chapter 18
1
Different Currencies and
Exchange Rates
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Each country issues and uses its own
currency, instead of using a common
currency.
To keep things simple, pretend that there
are only two countries.
Think of the home country as the United
States and the foreign country as China.
The China nominal quantity of money, Mf, is
measured in RMB. The U.S. nominal
quantity of money, M, is in Dollars.
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Different Currencies and
Exchange Rates
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Exchange market, on which
participants trade the currency of
one country for that of another.
the nominal exchange rate is the
number of RMBs received for each
dollar.
Let ε denote the nominal exchange
rate between RMBs and dollars.
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Example: Chinese Yuan
100美元
1000.00
800.00
600.00
400.00
200.00
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Macroeconomics
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Different Currencies and
Exchange Rates
Macroeconomics
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Different Currencies and
Exchange Rates
Macroeconomics
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Purchasing-Power Parity
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Sometimes countries allow their nominal
exchange rates to move freely in response
to market forces. These systems are called
flexible exchange rates.
In other circumstances, countries try to
maintain a constant nominal exchange rate
with respect to another currency, often the
U.S. dollar. These systems are called fixed
exchange rates.
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Purchasing-Power Parity
Macroeconomics
Chapter 18
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Purchasing-Power Parity
Macroeconomics
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Purchasing-Power Parity
Macroeconomics
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Purchasing-Power Parity
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The PPP Condition and the Real Exchange
Rate
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The U.S. price level, P, is measured in dollars
per unit of goods. We denote the Chinese price
level (or foreign price level) by Pf , measured
in RMB per unit of goods.
Assume that the goods produced and used in
both countries are physically identical.
We also ignore any transportation or other
transaction costs for buying and selling goods
in the two countries.
Macroeconomics
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Purchasing-Power Parity
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The PPP Condition and the Real
Exchange Rate
1/P = ε·(1/Pf)
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quantity of goods that can be bought in U.S.
= quantity of goods that can be bought in China
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Purchasing-Power Parity
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purchasing-power parity
ε = Pf/P
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nominal exchange rate
= ratio of foreign price to home
price
Macroeconomics
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Purchasing-Power Parity
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The PPP Condition and the Real
Exchange Rate
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purchasing-power parity (PPP).
This condition means that the
purchasing power in terms of goods for
dollars (or RMB) is the same regardless
of whether households buy goods in
the United States or China.
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Purchasing-Power Parity
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什么时候 PPP Condition 不一定成立？
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各国产品不一样。
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（想一想，上海的麦当劳和波恩的麦当劳产品真
的是一样的吗？）
非贸易商品的存在。
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（例如，住房）
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Purchasing-Power Parity
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The PPP Condition and the Real
Exchange Rate
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real exchange rate= (ε/Pf ) / (1/P)
real exchange rate is the ratio of
goods that can be bought in China (say,
with $1) to goods that can be bought in
the United States (also with $1).
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Macroeconomics
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Purchasing-Power Parity
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GDP的国际比较
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中国2004年的名义人均GDP是12336元
按照1：8计算，折合1542美元
这样的计算有什么问题？
如果考虑PPP呢？
这样的计算又有什么问题？
Macroeconomics
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Purchasing-Power Parity
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The PPP Condition in long run
ε = Pf/ P
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real exchange rate= ε/(Pf/P)  1
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预测一下人民币汇率的走势：4.3  1
ε下降
 Pf/P上升
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Purchasing-Power Parity
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growth rate of Pf/P = ∆Pf/Pf − ∆P/P
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growth rate of Pf/P = πf − π
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growth rate of real exchange rate
= ∆ε/ε − (πf − π )
 E.g. 30years from 4.3 to 1 implies
-4.8%
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Purchasing-Power Parity
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The Relative PPP Condition
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purchasing-power parity, relative form:
∆ε/ε = πf − π
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growth rate of nominal exchange rate
= foreign inflation rate− home
inflation rate
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Purchasing-Power Parity
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Purchasing-Power Parity
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Interest-Rate Parity
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Option 1: Hold U.S. bond
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dollars received in year t+ 1 = 1 + i
Option 2: Use exchange market and
hold Chinese bond
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dollars received in year t+ 1 =
εt·(1+if)/εt+1
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Interest-Rate Parity
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1+i =εt·(1+if)/εt+1
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return on holding U.S. bond
= return on using exchange market
and holding Chinese bond
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Interest-Rate Parity
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1+if = (1+ i) · (εt+1/εt )
The growth rate of the nominal
exchange rate is
∆εt/εt = (ε t+1− ε t)/εt
∆εt/εt = (ε t+1/εt )− 1
1 + i f = (1 + i)·(1 + ∆εt/ε t)
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Interest-Rate Parity
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i f − i = ∆εt/εt
interest-rate differential
= growth rate of nominal exchange rate
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i f − i = ∆(εt/εt)e
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Interest-Rate Parity
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Real interest-rate
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∆ε/ε = πf− π
In terms as expected rates of change:
∆(εt/εt)e= (πf)e−πe
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Interest-Rate Parity
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if − i = (πf)e−πe
interest-rate differential
= difference in expected inflation rates
if − (πf)e= i− πe
foreign expected real interest rate
= home expected real interest rate
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Interest-Rate Parity
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real exchange rate= ε/(Pf/P)
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If it is smaller than 1:
The expected growth rate of the
nominal exchange rate, (∆εt/εt) e , must
be greater than the expected growth of
Pf/P, which equals the difference
between the expected inflation rates,
(πf)e − πe
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Interest-Rate Parity
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Instead of the equality in equation
we have the inequality:
∆(εt/εt)e> (πf)e− πe
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If we substitute this inequality into
the interest-rate parity condition in
equation
if − i > (πf)e− πe
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Interest-Rate Parity
 if
− (πf)e> i− π
foreign expected real interest rate
> home expected real interest rate
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i.e., we expect that the price level in
those countries whose real exchange
rate smaller than 1 will decreases.
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Fixed Exchange Rates
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The fixed-exchange-rate regime that
applied to most advanced countries from
World War II until the early 1970s was
called the Bretton Woods
Under this system, the participating
countries established narrow bands within
which they pegged the nominal exchange
rate, ε, between their currency and the
U.S. dollar.
Each country’s central bank stood ready
to buy or sell its currency at the rate of ε
units per U.S. dollar.
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Fixed Exchange Rates
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Purchasing Power Parity Under
Fixed Exchange Rates
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ε = Pf/P
Pf = εP
if the nominal exchange rate, ε, is fixed,
πf = π
Macroeconomics
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Fixed Exchange Rates
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Purchasing Power Parity Under
Fixed Exchange Rates
i f − i = ∆εt/εt
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Under fixed exchange rates:
if = i
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Fixed Exchange Rates
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The Nominal Quantity of Money
Under Fixed Exchange Rates
Mf = Pf· L(Yf,if)
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Pf = εP.
Mf = ε P · L(Yf, i)
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Fixed Exchange Rates
Macroeconomics
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Fixed Exchange Rates
Two possible results of increasing M under
fixed exchange rate regime:
1. The decline of the international reserves,
even devaluation.
2. Trade barriers to limit free trade.
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Fixed Exchange Rates
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a devaluation, which is a reduction
in the value of RMB compared to
the dollar.
Macroeconomics
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Fixed Exchange Rates
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Devaluation and Revaluation
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An appreciation of the Chinese
currency—an increase in 1/ε, the
number of dollars that exchange for
each yuan— is called a revaluation.
Macroeconomics
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Flexible Exchange Rates
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Since the early 1970s, most advanced
countries have allowed their currencies to
vary more or less freely to clear the
markets for foreign exchange.
The difference from the fixed-exchangerate setup is that the nominal exchange
rate, ε, is not a fixed number. Because of
adjustments of ε in a flexible-rate regime,
Pf need not move in lockstep with P even
if the absolute PPP condition always holds.
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Fixed and Flexible Exchange Rates: A
Comparison
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An extreme form of fixed nominal
exchange rate is a common
currency.
a fixed-exchange rate system
precludes an independent monetary
policy, at least in the long run.
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Fixed and Flexible Exchange Rates: A
Comparison
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One advantage of a flexible nominal
exchange rate is that it introduces
an additional way to satisfy the PPP
condition, Pf = εP
The independence of monetary
policy under flexible exchange rates
is not always desirable.
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Extra: Mundell-Fleming Model
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Open economy
NX(e) is net export
e is the exchange rate
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Small country
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Fixed price
Macroeconomics
r=rf
Chapter 18
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Extra: Mundell-Fleming Model
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IS : r=rf
Y=C(Y)+I(rf )+NX(e)
e
Y
Macroeconomics
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Extra: Mundell-Fleming Model
r
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LM:
M/P=L(Y,rf )
r=rf
e
Y
Y
Macroeconomics
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Extra: Mundell-Fleming Model
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IS : r=rf Y=C(Y)+I(rf )+NX(e)
LM: M/P=L(Y,rf )
e
Y
Macroeconomics
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Extra: Mundell-Fleming Model with
floating exchange rate
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LM:
M/P=L(Y,rf )
M increases
e
Y
Macroeconomics
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Extra: Mundell-Fleming Model with
floating exchange rate
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M increases
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Closed economy: r decreases and
Investment rises. Y increases.
Open economy: r is fixed, hence,
capital flows out. e decreases and net
export rises. Y increases.
Macroeconomics
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Extra: Mundell-Fleming Model with
fixed exchange rate
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e=e*
e
Y
Macroeconomics
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Extra: Mundell-Fleming Model with
fixed exchange rate
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e=e* M increases ??
e
Y
Macroeconomics
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Extra: Mundell-Fleming Model with
fixed exchange rate
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Summary
Floating
Y
e
NX
Fixed
Y
e
NX
Monetary policy
M
Macroeconomics
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